Twenty years ago, few would have predicted that Russia would soon experience an economic boom. The country’s economy had been shackled for decades by Soviet rule. It managed to produce oil, nuclear warheads, Kalashnikov rifles and very little else of interest to the market economies in the West.

Then came the reforms of former Soviet President Mikhail Gorbachev and perestroika followed by the revolution of former President Boris Yeltsin and free markets. Seemingly overnight, a clutch of young businessmen — many of them with ties to Yeltsin — cobbled together billion-dollar fortunes by scooping up the few valuable remnants of the Soviet system, mainly its natural-resource producers. At the same time, many average Russians found themselves penniless as their government-guaranteed jobs disappeared. Their only remaining assets were apartments that had been privatized during the free-market fervor.

For the West, Russia in the 1990s became fascinating political theater — who can forget Yeltsin thwarting a coup by climbing atop a tank in Red Square — but an economic sideshow. In an era of cheap oil prices, the country’s natural-resource wealth — Russia has the world’s largest natural gas reserves and second-largest oil reserves — didn’t matter. Its role as an economic also-ran seemed assured when, in 1998, the government devalued the ruble and defaulted on its debts.  

Today, Russia is booming. Thanks mainly to lofty oil prices, the Russian economy has grown by an average of more than 6% a year for the last eight years. The oil and gas businesses are surging, of course, but so are consumer-goods producers and the real-estate sector, especially in Moscow and St. Petersburg. Luxury items have arrived as well. Italian sports car maker Lamborghini opened a Moscow dealership last year, and American designer Ralph Lauren has announced plans to open two stores in the city.

Russian companies, for their part, are increasingly selling shares to the public, including on the New York and London stock exchanges, and Westerners are finding Russia’s stock market a profitable, if risky, place to invest. Russian firms have even begun to expand in the West. Lukoil, one of the country’s largest oil producers, sells its gasoline in the United States through 2,000 Lukoil-branded service stations.

Most Russians haven’t seen their fortunes soar like those of the country’s handful of billionaires, known colloquially as the “oligarchs,” but they are far better off than they were a decade ago. The middle class is swelling: About one in five Russians lives in poverty today, compared with about one in three in 2000, according to the Paris-based Organization of Economic Co-operation and Development (OECD).

A Need to Diversify

Despite all of its recent advances, Russia faces a host of challenges. Average Russians remain poorer and sicker than their peers in the developed world. The dissolution of the Soviet Union left the health care system in shambles and bequeathed the country far lower life expectancies than its European neighbors. Though the economy has begun to diversify, oil and other natural resources still account for 80% of exports. On top of that, Russia has so far failed to develop the sort of knowledge-intensive industries — outside of the relatively small aeronautics sector — that power the world’s strongest economies.

“Russia has a high level of educated people,” says Serguei Netessine, Wharton professor of operations and information management and a Russian native. “But when you look at how that education is put to use, the picture isn’t very good. Researchers in Brazil, Poland and India generate two to three times as many scientific publications. In Germany and Spain, it’s six times. You can look at other indicators, too. Germany generates 100 times more patents per capita than Russia.”

Even worse, corruption continues to gum up commerce, with bureaucrats seeking bribes to, say, hand out permits or process paperwork. Transparency International, a nonprofit group, ranks Russia as tied for 121st in the world on its Corruption Perceptions Index, putting it on par with such places as Rwanda and the Philippines. Western European nations dominate the top of list, with Finland finishing first as the country perceived as least corrupt. Brazil, China, and India, often considered Russia’s peers as developing economic powerhouses, are tied for 70th.

The enigma at the center of Russia’s economic transformation is President Vladimir Putin. If most Westerners know anything about Putin, besides his current job, it’s his former career as an agent in the KGB, the Soviet Union’s secret police. Some commentators interpret nearly all his moves as attempts to restore to the Kremlin, Russia’s executive branch, to the omnipotence that it enjoyed during the Soviet years.

That’s a misreading of Russian reality, says Valery Yakubovich, a Wharton management professor and Russian native.For one thing, “Nobody in Russia wants to go back,” he says. For another, Putin doesn’t have the power to push the country backwards, even if he wants to. “Around him there are various cliques, and he’s trying to balance them,” Yakubovich explains. “The government’s not completely under his control or design.”

Putin has centralized power, taken control of the appointment of regional governors and increased state ownership in key industrial sectors like oil and gas. The state, for example, now owns a controlling stake in Gazprom, Russia’s largest natural gas company. “In 2003, state-controlled companies accounted for about 16% of crude production,” the OECD notes. “By end-2005, that figure had reached 33.5%.”

Putin has cracked down on dissent and political rivals, too, and clamped down on the media, especially television. Most notoriously, he made an example of Mikhail Khodorkovsky, former chairman of the Yukos oil company, who had begun to bankroll media and political groups opposing the president. Khodorkovsky sits in a Siberia prison, convicted of tax evasion and facing still more charges. His former company is being broken up and sold off to satisfy the tax claims.

Russia watchers differ on whether Khodorkovsky’s prosecution was politically motivated or signaled rough justice for earlier sins. Maria Gordon, a Russian native who co-leads Goldman Sachs Asset Management’s Global Emerging Market Equity division, calls it a personal vendetta on the part of the president. “Mr. Putin saw him as a major challenger,” she says. But Phil Nichols, a Wharton professor of legal studies and business ethics who has studied corruption in Russia, argues that Khodorkovsky took actions to warrant punishment. “It’s interesting that Khodorkovsky became a poster child for the abuses of Putin,” he says. “A couple of years before that, he was the poster child for the abuses that people like him inflicted on foreign investors. At one point, he had foreign investors removed from a public meeting. He rigged the purchase of Yukos. He stole billions from the country and consistently broke the rules. There’s every reason for him to be prosecuted.”

Either way, Khodorkovsky’s prosecution and the government’s seizure of his company’s assets could undermine Russia’s efforts to attract foreign investment. According to the OECD, “The case highlighted larger institutional weaknesses that are deep-rooted and affect even companies that face no risk of expropriation: The rule of law is still weak, and the scope for arbitrary official behavior is great.”

“25 Times Their Money”

If Putin has shown himself to be a political authoritarian, he has demonstrated far more open-mindedness and flexibility when it comes to economics (a subject in which he earned a doctorate). “He’s created a situation where my investors have made 25 times their money,” says Bill Browder, chief executive of Hermitage Capital Management, a leading investor in Russia. “He’s played a big part in creating economic stability. He’s a human being with human flaws, but it’s hard to argue about what he’s done for the economy.”

Putin has made fiscal responsibility a hallmark of his presidency. As oil revenues have flooded in, he has paid off the country’s debts to foreign creditors. And he has husbanded much of the rest of the government’s oil windfalls into a special reserve fund, which has grown to about $80 billion. 

The OECD credits Putin’s economic management with containing inflation, despite the gush of oil money. Over the last five years, the inflation rate has dropped down from 15% to 9%, which is low by Russian standards.

His fiscal restraint has some investors fretting about the country’s next presidential election, which is scheduled for early next year. While Russian law bars Putin from seeking a third term, he is so popular at home that many Russians would relax the rules to allow him to seek a third term. He has said that he intends to step down, though Russia watchers speculate that he will land in a position that keeps him close to the center of power.

The leading candidates to replace him appear to be two of his protégés: Dmitri Medvedev and Sergei Ivanov, who both hold the title of first deputy prime minister. Medvedev, a lawyer by training, leads Putin’s special reform projects in areas like health care and education and is seen as more economically liberal. Ivanov, a former KGB agent, was, until his recent promotion, defense minister. He’s seen as hawkish on foreign policy and more conservative economically. 

“I think the Russian people would support Putin staying in power indefinitely,” says Dmitri Trenin, deputy director of the Carnegie Endowment for International Peace’s Moscow Center. “If you look at the way people live today compared with when he came to power, they will say that living standards are twice as high. More importantly, there’s a sense of stability that has replaced the chaos of the 1990s. They will also say that Putin has restored some pride and respect for Russia abroad.”